Evaluating the portfolio rebalancing hypothesis in the presence of the international goods market

A relatively recent approach to examining the currency-equity return relationship argues that the portfolio rebalancing activities of investors gives rise to an Uncovered Equity Parity condition (UEP), whereby higher relative equity returns in one country are associated with a currency depreciation as international investors re-jig positions to maintain optimal portfolio targets. Motivated by evidence that the UEP does not hold for large commodity exporters of Australia, Canada and New Zealand, this paper examines the impact the commodity market has on the currency and equity market interaction by applying a latent factor model designed to distinguish between comovement and spillovers. In order to contextualise the results, the same model is estimated for a sample of three benchmark OECD countries comprising Denmark, Sweden and the United Kingdom. The evidence is not supportive of the UEP for either country group, and there is particularly strong evidence of positive feedback between currency and equity markets for the benchmark OECD group. More generally, there are significant interconnections between all three asset markets for both the large commodity exporters and the benchmark OECD countries. This is unsurprising given that commodity prices play a role in transmitting demand and supply shocks to asset markets, and are also increasingly connected to traditional asset markets as a result of evolving investor behaviour.